Annuities and Retirees: Beyond the Math

On a recent family road trip, my 6-year-old son asked the question every parent has heard at least a million times, one he had asked at least 10 other times on that trip: “How much longer until we’re there?”

On that occasion, rather than answering him, I got lost in thought about how his uncertainty wasn’t all that different from what happens when we try to plan retirement spending. Hear me out: From where I sat, the answer was clear – I could look at Google Maps and see we had about 10 miles, or 47 minutes, left on our trip (did I mention that we live in Los Angeles?).

Longevity Risk Makes Retirement Spending Uncertain

But from his seat, with no clear view of the screen, he simply had no idea what the rest of the trip would be like. Determining a spending plan in retirement requires knowledge of a different kind of remainder (our time left to live), yet we occupy the same seat as children – we have no way to truly predict how long that time will be.

For many people, this kind of uncertainty is where an annuity can fit. It was the topic of our final installment in the “Beyond the Math” mini-series on “The Behavioral Divide” podcast. To better understand the psychology behind annuities, I spoke with University of Illinois Professor Jeff Brown, who has spent the past 30 years studying annuity decision-making, and with David Bush, chief investment officer at Trajan Wealth.

What Is an Annuity?

As Brown noted, in its most basic form, an annuity is "just an exchange of a sum of wealth for a stream of income." But annuities can then differ along two dimensions, which Brown frames as a two-by-two grid.

The first is timing: Immediate annuities pay income right away in exchange for a premium, whereas deferred annuities collect a premium now and begin paying income at a later date.

The second concerns the structure of payouts: Fixed annuities exchange your premium for a set payment for the rest of your life, while variable annuities are invested in a diversified pool of assets, so the payout can rise or fall with the market.

Throughout our conversation, it became apparent that, when it comes to annuities, as with the other topics (Social Security and mortgages) we discussed in our “Beyond the Math” series, two aspects matter greatly: how a product is framed and what that product is for.

How Framing Shapes Annuity Decisions

Several years ago, Brown and his colleagues conducted influential research in which they presented information about annuities to people, with the product subtly described using either an investment or a consumption frame.¹ For instance:

• Investment frame: "Mr. Red invests $100,000 in an account that earns $650 each month for as long as he lives."

• Consumption frame: "Mr. Red can spend $650 each month for as long as he lives in addition to Social Security."

It’s the same product, of course, but with different framing. As Brown described it, framing an annuity in terms of consumption moved about half the people who would otherwise have rejected the annuity to prefer it (over taking a lump sum).

Consider the reason: The investment frame brings to mind the possibility of “losing” the initial $100,000 if you die early. The consumption frame removes any mention of the account balance and instead focuses on spending potential.

What’s interesting here, and where Brown and Bush agreed, is that the entire American retirement system effectively orients people toward the investment frame by encouraging them to think in terms of accumulation (e.g., “What’s your number?”).

But with the probability of living into one’s 80s or 90s considerably higher now than it once was, as Bush pointed out, having insurance against outliving one’s savings may be even more important.

Bush further noted that the very way an advisor raises the topic of annuities is the real-world version of Brown’s framing experiment. For instance, if an annuity is discussed in the immediate context of a client’s portfolio, it may inadvertently prompt them to think of annuities in investment terms (making them less attractive).

Instead, it may be wiser to discuss risk and ask whether an annuity, as a consumption device that hedges against outliving one’s savings, “fits” that client. Along these lines, annuities may not, of course, be right for everyone. If a client, for instance, has a strong bequest motive, a shorter-than-average life expectancy, or even a need for cash in the near future, annuities may not be suitable for them.

Why Your Future Self Matters in Retirement Planning

Going deeper, Brown asked a question he once posed to government officials at a congressional hearing: “Why do we even save for retirement?” Is it to have the largest lump sum possible at age 65, or is it to maintain our living standards for the rest of our lives? Of course, it’s the latter. But just asking that question raises a deeper one: What do you want the last 10 to 15 years of your life to look like?

Brown suggests that a conversation about retirement spending should start at the end, with clients being asked to imagine what they will be like at age 90. Of course, there can be a disconnect between who someone is at 65 and who they may become 25 years later.

But planning for a version of yourself you don’t yet know is a form of care for an older version of you. One fact of aging is that most of us will experience some form of cognitive decline over time. As Brown pointed out, having income coming in each month helps manage that decline by taking one more worry off the table.

The “math” may point to an annuity as a potentially wise way to help protect against outliving one’s savings. But relying on math alone may overlook the fundamental psychology behind this type of purchase.

As Brown said, when he was helping his mother plan her retirement, she called him worried, asking whether she would run out of money. As an economist, he ran through probabilities and showed her spreadsheets. A few months later, she called with the same question – the adult and more serious version of “when will we be there?” – which is when it occurred to him that “all the probabilities in the world weren’t going to do it for her. She needed a sense of certainty.” That sort of certainty, rather than a rate of return, may be what an annuity is actually for.

Balancing Certainty, Flexibility and Peace of Mind

Of course, there are always trade-offs. Maintaining an allocation through retirement, with some level of stocks for growth and bonds for risk management, provides less certainty about longevity risk but offers transparency into the current account value and liquidity if needed.

By contrast, annuitizing all your assets guarantees a steady monthly income and helps protect against longevity risk – but only by surrendering your lump-sum nest egg and the liquidity it provides. The key is understanding the options and trade-offs, considering both the math and individual psychology, to determine what’s best suited to each person’s unique goals and objectives.